Monday, August 29, 2011

Stock Picking for Long term Investment Holdings

Share market investment has confused lot of people. Majority of people we see these days who talk about share market are traded, they believe in short term holding strategy. They are more gamblers than investors. The confusion is more for those people who has long term investment philosophy but they do not how to select stocks good for long term holding.

This article is mainly written for those long term investors who want to buy shares for long term holding. The indicators that justify a share for long term indicators are not same as that for short term holdings. Hence the team of getmoneyrich has decided to list down some key long term indicators that justify a share’s purchase for long term holding strategy.

Strong Business Fundamentals will justify long term holding
Why we actually purchase a share? A trader will answer this question differently than a long term investors. For a trader, market price appreciation is a key but for a long term investors ‘regular streams of decent future cash in-flow’ is the main goal. Let us see what key indicators confirms inflow of future cash.

If the company has a philosophy of sharing profits with shareholders in the form of Dividends
Not all companies pay dividends. You must have noticed that the growth stocks do not pay as high dividend as big and established companies. Big and established companies pay dividends because of mainly two reasons (1) They do not need too much fund for their expansion plans, as they have already reached a stage of self sufficiency (2) Their predictability of future profit is high hence they can afford to flaunt themselves by sharing profits with its shareholders.

This also helps them to keep they shareholders glued to their shares even though they do not have a high growth probabilities. It must also be noted by investors that just seeing that the company is paying dividends will not solve the case. Two things are important to note (1) If dividends are paid with consistency? It should not happen that one year high dividend is paid and for next several years dividends are paid like peanuts. (2) After dividend consistency, it is also important to note that what dividend yield is being generated by the share.

Dividend yield is dependent on the value of dividend paid per share and on the market price of share. If market price of the share is too high, the dividend yield will be low. So the value of dividend yield well justifies the purchase of a particular stocks. Ideally speaking, a quality stock with dividend yield less than 3% is not well justified.

Always look at the value of Price Earning Ratio (P/E) before buying a long term stocks.

As a rule of thumb, any stock having a P/E ratio of more than 15 can be considered as overvalued. Inverse of P/E ratio is called earning yield. Inverse of P/E=15 = 6.67%. Considering that fixed income securities investment (instead of shares) will fetch you a return on <6%, hence is a share is showing an earning yield of 6.67% it means it is profitable buy. But not all high P/E ratio stocks can be disqualified for long term holdings.

Like earning yield there is also a parameter called PEG ratio. If a stock has a PEG ratio of <1, it qualifies as good long term holding. Suppose a stocks which has P/E ratio of 25, also has a Earning Growth (for last five years) of 26% per annum. It means the PEG ratio (PE/EG = 25/26 = 0.961) is <1. Though the stocks has very high P/E ratio but robust earnings growth justifies the purchase of this stock.

For normal investors the way to check if a stocks is overvalued on basis of P/E ratio is to compare it with its competitors. Suppose a stock X is operating in large size steel sector. Compare P/E of X with other large steel companies and evaluate if X is overvalued or undervalued as compared to its peers. But this is only step one. One must better analyze P/E ratio on basis of earning yield and PEG ratio.

We have already said this, robust earnings growth makes a good long term buy
Net income/ profits of a company is a great value indicator and even better is earning growth over a period of time. Suppose two companies, one which has $10 million income shows earning growth rate of 5% per annum and another company which has $8 million income but has growth rate of 7% per annum, long term investors shall choose the later. Of course the dividend paying philosophy will also play an important role here. But in a nutshell we can say that any company which has consistent earning / earnings growth over a period of time qualifies for long term holding. A highly wavering earnings is a bad indicator, even though in some years the earnings may be outstanding.

Economy of the nation will also contribute in the long term profitability of a company
At times companies taken debt to do its business. Companies can take debt for two reasons, One, To increase their profit leverage (& or), two, to manage their cash flow. In times of good economic scenario, when interest rates are low, companies can use this debt to increase their leverage. But in moments of high interest rates, the same debt will more a burden (expense in income statement) than the leverage they can produce.

Suppose a company has profitability of 6% and interest rate of debt issued by banks is 6.5%, it means that the profitability of the company does not justify the long term loan. But in order to manage the cash flow requirement of the company the companies will be forced to take loan. This will only to the losses. So the economic situation of the nation has big influence on the long term performance of any company.

Not much companies can do improve the debt leverage of the company is the interest rates are high. So I will not comment more on this point. But short term cash flow management of the company is very important. Some key indicators that hints at ability of cash flow management is listed below:

(1) Net increase in cash/cash equivalents as compared to last year (cash flow statement) &
(2) Current ratio

If a current ratio of a company is two, it means that the company has a power to pay two times its present level of short term liabilities. The high the better. As a rule of thumb, current ratio of below 2 is not good for long term stock holding.

At any moment of time, economy of any nation can always be classified into three broad phases (1) Bull Phase, (2) Bear Phase & (3) Stagnant Phase. Majority of traders will love to enter into stock market during the bull phase. But a long term investor will love a bear phase. During this phase, even the best of stocks are trading at undervalued levels. So long term investors must grab such stocks at these price levels as dividend yield will be excellent at these price levels.

One parameter that dictates the decision of long term stock holding is dividend yield/ dividend consistency. Buying a stock which has been mispriced by the market (undervalued) will offer high dividend yields. A stock which is fundamentally strong and also offers high dividend yield will be a preferred stock for even the best of long term investors like Warren Buffett.
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